Corporate Services and
Economic Development Committee
Comité des services organisationnels et du développement économique
and Council / et au Conseil
7 November 2008/le 7 novembre 2008
Submitted by/Soumis par : Marian
Simulik City Treasurer / trésorière municipale
Contact Person/Personne ressource : Gerry Mahoney, Manager Treasury
Financial
Services/Services financiers
(613)
580-2424 x 21310, gerry.mahoney@ottawa.ca
SUBJECT:
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OBJET :
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Politique de
couverture contre les fluctuations du prix des produits de base |
That the Corporate Services and Economic Development Committee recommend Council:
1. Approve the Commodity Price Hedging Policy, attached as Document 1;
2. Approve the Procurement Strategy for Hydrocarbon Fuels such as Gasoline and Diesel Fuel, attached as Document 2; and
3. Amend the delegation of Authority By-Law 2005-503 to authorize the City Treasurer to award contracts in relation to the commodities defined and in accordance with the Commodity Price Hedging Policy.
Que le
Comité des services organisationnels et du développement économique recommande
au Conseil :
1.
D’approuver
la politique de couverture contre les fluctuations du prix des produits de base
énoncée dans le document 1;
2.
D’approuver
la stratégie d’achat d’hydrocarbures (essence et carburant diesel, p. ex.)
énoncée dans le document 2; et
3.
De
modifier le Règlement municipal no 2005-503 sur la délégation de
pouvoirs, afin d’autoriser le trésorier de la Ville à attribuer des contrats
relativement aux produits de base définis et conformément à la politique de couverture
contre les fluctuations du prix des produits de base.
Ontario Regulation 653/05 under the Municipal Act, 200, S.O.2001,c.25 requires a municipality to adopt a statement of policies and goals relating to the use of financial agreements to hedge commodity prices and costs before adopting a by-law authorizing a commodity price hedging agreement.
The proposed policy permits the City to enter into various financial agreements to limit the risk of unfavourable price changes in the underlying commodity being hedged. The primary objective of a commodity hedge agreement is to provide price stability by fixing prices for a specific commodity for a defined future period of delivery. The policy provides:
1. That approval of Council will be required prior to commencing a hedging program for each commodity;
2. That hedging arrangements should not normally exceed 85% of the estimated volume of the commodity required for use in any year;
3. That financial agreements may only be entered into with financial institutions meeting the minimum ratings set out in the Commodity Price Hedging Policy. These ratings are identical to the ratings set by the Province as the minimum rating such institutions must have to enter into other types of financial agreements such as bank loans, interest rate exchange agreements and interest rate bond forward agreements.
Financial markets offer a variety of mechanisms to limit the risk of adverse price changes in underlying commodities. Such mechanisms are widely used by producers, distributors and wholesalers to manage the risk of adverse price changes for a wide variety of goods including agricultural products, energy commodities, natural resources and precious metals.
The City has traditionally managed the purchase of certain products which are subject to frequent and sudden price changes through a variety of methods including locking-in a fixed price for a specific commodity for an extended period of time and entering into long term supply contracts which limit annual increases to specific inflationary indices or escalation formula which are common to specific products or services. The commodities involved typically include electricity, natural gas and diesel fuel. These strategies have met the City’s requirements and although they continue to be viable options in specific applications, are subject to conditions prevailing for the specific commodity at any point in time. In times of relatively scarce supply and likely increasing prices, a supplier may be reluctant to lock-in a long-term price in volatile conditions.
There is a wide variety of financial tools available to hedge the price risk of specific commodities. Each mechanism offers advantages and disadvantages.
One frequently used financial mechanism is a “swap” arrangement whereby the City would effectively pay a fixed price for a commodity such as diesel fuel, for a specific quantity for a set period of time. The City continues to purchase diesel fuel from its preferred supplier and the supplier remains responsible to make delivery as required under its contract. Under a swap transaction the City would:
· Enter into a contract with a supplier to provide a commodity for delivery as required and the City would pay the current market price prevailing at the time of delivery.
· Enter into a swap agreement with a financial institution which would require the City to pay a fixed price for an agreed volume for a specified period of time which would match as closely as possible the City’s requirements for the commodity.
· By entering into the swap agreement, the financial institution would pay the City a floating price corresponding to the price for the commodity prevailing at the time deliveries are made by the supplier.
· The floating price received by the City would offset the floating price paid by the City to the supplier, leaving the City with effectively paying a fixed price for the commodity.
The details of a specific swap arrangement for a specific commodity may be somewhat more complex than the above description. For example settlement of the floating price from a financial institution is usually based on an average of the prices during the month and the actual quantity delivered from the supplier may vary from the quantity set in the swap.
Another arrangement would allow the City to protect against prices for a commodity moving above a specific price (the strike price) for a period of time. Under this arrangement called a “call option”, the City would continue to pay its supplier the market or floating price but would receive compensation from the bank if prices rise above a pre-set price. Again the floating price is calculated as the monthly average of the daily settlement price for a commodity for a specific quantity. The City would receive a payment for any month during which the average price exceeds the specific agreed price. If the average price is less than the agreed price then the bank would not make any payment. The City would pay a fee called a premium, for having this option contract.
Procurement Strategy for Hydrocarbon Fuels
In conjunction with the Commodity Price Hedging Policy, a proposed
strategy to hedge the price of diesel fuel and gasoline is described in the
attached Document 2. The City purchases
45 million liters of diesel fuel annually.
The price of diesel fuel and gasoline has fluctuated enormously in the
past 12 months from a high of 1.26969 (August 2008) to a low of 0.8667 (October
2007). The ability to lock-in a fixed price is essential
to managing the cost of fuel in a fixed budget environment. The objectives and process set out in
Document 2 reflect existing practices but also provide the ability to take
advantage of hedging the price of fuel through financial agreements if there is
a benefit to such an arrangement when a price is being fixed. Council approval is requested to permit the
hedging of hydrocarbon fuels through supply contracts or financial agreements.
The proposed Commodity Price Hedging Policy will not replace existing supply strategies but will provide alternatives to limit the risk of unfavourable price changes in the underlying commodity. On 22 October 2008 Council approved a report (ACS2008-BTS-RPM-0041) concerning energy management and investment strategy, which contained a number of measures to manage the price volatility of electricity and natural gas. The proposed Commodity Price Hedging Policy does not change any of the measures described in that report but offers additional options to manage the risk of unfavourable price changes through various financial products and agreements. For other commodities such as diesel fuel, suppliers are reluctant to provide long term price commitments for future deliveries and the proposed policy would allow the City to consider other mechanisms to manage this price risk.
The proposed policy is an administrative matter and the public consultation process is not applicable.
The proposed Commodity Price Hedging Policy will allow the City to consider a variety of financial agreements to manage the risk of adverse price changes for a variety of commodities required by the City. The primary objective of a commodity price hedge agreement is to provide price stability by fixing prices for a specific commodity for a defined future period of delivery thus reducing the impact of sudden unanticipated price increases.
Document 1 – Commodity Price Hedging Policy
Document 2
- Procurement Strategy for Hydrocarbon Fuels
Following consideration at Corporate Services and Economic Development Committee, this report will be forwarded to Council for its consideration.
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The City of Ottawa may enter into various commodity price hedging agreements to fix, directly or indirectly, or enable the municipality to fix the price or range of prices to be paid by the municipality for the future delivery of some or all of the commodity or the future cost to the municipality of an equivalent quantity of the commodity.
Price
instability of some commodities required by the City can lead to budgeting
challenges and increase financial risk. The primary objective for the City’s
commodity price hedging policy is to reduce financial risk by providing price
stability and protection against the affects of adverse market conditions.
This
policy applies to all Financial Agreements that are entered into by the City
for the purpose of fixing future prices through commodity price hedging, as
well as to those employees responsible for the control, management, or
purchasing of hedging agreements.
A
commodity price hedging agreement may only be undertaken if the agreement is in
compliance with the Ontario Regulation 653/05. Requirements include the
following:
a) The Financial Agreement must fix, directly or indirectly, or enable the municipality to fix the price or range of prices to be paid by the municipality for the future delivery of some or all of the commodity or the future cost to the municipality of an equivalent quantity of the commodity.
b) The City may enter into a Financial Agreement only for the future delivery of some or all of a commodity or the future cost of an equivalent quantity of a commodity. A financial agreement shall not be entered into for the purpose of speculative investing; and
c) The City is prohibited from selling or disposing of the Financial Agreement or an interest in the Agreement. An exception to this requirement exists if there is a sale or change of use of real property to which the Agreement applies or the City ceases an activity for which the commodity was being acquired.
The Commodity Price Hedging Program is a mechanism for managing financial risk by establishing a level of certainty for future prices for specific commodities, however, there are risks inherent with using these instruments. These risks include and should be mitigated as follows:
a) Demand risk is where
in the City may use less of the commodity than the forecasted requirement
leading to the possibility of excess hedging.
b) Market risk is where in there may be opportunity lost if the price of the commodity falls below the hedged purchase price. There are some financial agreements which the City may enter into which will allow the City to benefit from price movements within a range of prices while protecting the City against price increases above an agreed limit. In such agreements if the current market price falls below the lower price or “floor”, then the City would be responsible for paying the price differential below the “floor” price.
The financial loss on the hedge contract from a price drop may be offset by purchasing the commodity in the spot market at the lower favourable price. Conversely, if the price of the commodity increases, the City would realize a net gain on the hedge.
c) Competitive price risk is where a competitive price hedge agreement may not be available in the market or available only at an undesirable price. This may occur during volatile market conditions or when there is uncertainty on the future supply of a commodity. As part of its analysis, staff will monitor the market and will consider other options including the use of fixed price contracts and/or purchasing on the “spot market”.
Commodity price hedging shall be undertaken in a manner to limit the risk of adverse prices changes and potential changes in demand by managing the term of hedging agreements and the proportion of the commodity to be hedged.
§ Term of Hedging Contracts
The term of a hedging contract will be chosen to balance price stability with the flexibility to adjust to changing market conditions and demand for the commodity within the City. Consideration will be given to demand cycles, price volatility, and comparable industry purchasing practices when establishing the term of a financial agreement.
Notwithstanding, it will be the City’s practice to only
enter into a hedging program for a maximum term of six years. Should market conditions and City requirements warrant
longer terms, a commodity hedging agreement may be entered into for terms
longer than six years as may be approved by the City Treasurer.
§ Proportion of Commodity to Be Hedged
While any proportion of the total or maximum City demand for a commodity can be hedged, any risk of over hedging can be avoided by selecting a proportion that is less than the forecast demand. The measurement of forecasted demand will be specific to the City’s requirements.
In addition, by limiting the amount of a commodity to be hedged to an amount less than the full requirements for any year, the City will be able to take advantage of any favourable price changes for the unhedged quantity.
The statutory limitations on the sale of Financial
Agreements require that the City must exercise caution in order to retain
flexibility to respond to demand uncertainty. This policy provides that
the amount of a commodity to be hedged be less than 85% of the forecast demand
for any year. Where the forecast demand has a high level of uncertainty,
hedging a smaller proportion of the demand is appropriate. Conversely,
when demand can be forecast with some degree of certainty, the City may hedge
greater amounts as may be approved under delegated authority of the City
Treasurer.
d) Credit risk or “counterparty risk” exists in the event that the commodity price has risen and the counterparty cannot fulfill the terms of the agreement. Agreements are usually with counter parties such as large financial institutions but may be with another entity such as a large supplier. Although default is considered a remote risk, risk control measures will be undertaken prior to entering into a Financial Agreement. The City will enter into Financial Agreements to hedge a commodity price with financial institutions with a minimum rating of A1 from Moody’s Investor Services, or A+ from Standard and Poor’s or A (high) from Dominion Bond Rating Services. The risks of fixing a price for a commodity for a longer period with a supplier are mitigated by the fact that the City will only make payments for commodities received, thus if product are not delivered the City will not be responsible for making payments. However the prices paid to replace product not delivered will be current market prices.
The following risk control measures are to be applied in a manner so as to limit financial risk exposure:
o limiting the City ’s exposure to a counterparty based on credit ratings and on the degree of regulatory oversight and regulatory capital;
o the use of standardized agreements; and
o ongoing monitoring with respect to the agreements.
Risk may also be mitigated through participation in a third
party pool based program or by placing Financial Agreements with multiple
counterparties.
Partnership Agreements with other Public Sector
Partners
Under some circumstances it may be beneficial for
the City to enter into partnership agreements where it is anticipated that a
financial benefit can be achieved. Partners shall be within the public sector
and may include municipalities, universities, school boards and hospitals, or
buying groups organized by municipal organizations such as the Ottawa Carleton
Energy Purchasing Group (OCEPG).
In the latter case, the “buying group” may
act as an agent for the City, including purchasing larger quantities of a commodity
on more favourable terms than buying the commodity on its own.
In principle, a partnership or agency
arrangement is an acceptable practice where the benefits can be clearly
delineated. Partnership or agency agreements will be considered an option under
the terms of this policy.
Commodity Price Hedging Contract Acquisition
Hedging contracts will be acquired on a competitive basis. Staff of the
City may solicit proposals from financial institutions to provide hedging
arrangements or where desired, may use the futures market to acquire hedging
contracts. The City may enter into a
financial agreement with one or more institutions where apportioning the total
of the agreement is expected to provide reduced costs and/or it is desirable to
diversify the counterparty risk to more than one financial institution.
Requirements
for Outside Advice
City staff will be expected to have sufficient knowledge to prudently evaluate standard Financial Agreements or related contracts. However, should in their opinion the appropriate level of knowledge not exist, or as otherwise directed, outside financial and/or legal advice will be obtained.
Authorized
Commodities for Price Hedging Purposes
The definition of commodity provided in the definitions section of this
policy mirrors that of the applicable legislation. However, for the purposes of
this Policy, commodities that may be hedged are as follows:
o electricity;
o hydrocarbon fuels such as gasoline, diesel fuel, and natural gas;
o
other commodities used by the City ,
as determined by Council.
Reporting Requirements
In addition to information requested by Council or that the City Treasurer considers appropriate, the City Treasurer, together with the Deputy City Manager(s) of the operating department(s) engaged in commodity purchase agreement(s), shall submit on an annual basis to Council a detailed report on all subsisting Financial Agreements. The report will contain the following information and documents:
o A statement about the status of the agreements during the period of the report, including a comparison of the expected and actual results of using the agreements;
o A statement indicating whether all of the agreements entered during the period of the report are consistent with the City ’s statement of policies and goals relating to the use of Financial Agreements to address commodity pricing and costs; and
o A statement of transactions with financial institutions.
Approvals
Approval by Council will be
required prior to commencing a hedging program for each commodity. Approval may
be sought concurrently with the initial purchase of a commodity or at some
point during the term of a commodity purchase contract. The subsequent Financial Agreements must be approved by the City Treasurer
or their delegate.
Delegation
of Authority
The City Treasurer will have the
overall responsibility for the commodity price hedging program which involve Financial Agreements and will have responsibility
for directing/implementing the activities of the commodity price hedging
program as well as the Officers and staff of the City
acting in compliance with this policy shall have the necessary authority to
carry out the responsibilities identified within the policy.
Notwithstanding,
the City may delegate specific authority to an “agent” of the City as within “Partnership
Agreements with other Public Sector Partners “ within this
Policy. The authority delegated will be strictly governed by the terms of an
agency contract that will be approved by Council.
All officers and employees responsible for commodity price hedging agreements will follow the standard of care identified in this policy. No person shall be permitted to engage in a commodity price hedging activity using Financial Agreements except as provided for under the terms of this policy.
The City Treasurer will be responsible for all activities undertaken, and shall establish a system of controls to regulate the activities of staff and exercise control over those staff including:
o Establishing delegation of authority to persons responsible for commodity price hedging activities.
o Reviewing and recommending the financial and business aspects of any Financial Agreements to be utilized in hedging a commodity price;
o The signing and execution of documents on behalf of the City and perform all other related acts with respect to Financial Agreements; and
o Ensuring that all reporting requirements identified within this Policy are met.
Deputy
City Managers (DCM’s) are responsible for determining an overall Commodity Hedging
Strategy for commodities under their control and custody. Notwithstanding the
strategy adopted, it is their responsibility to determine the forecasted demand
for the commodity.
The
Municipal Act, 2001, S.O. 2001, c.25
The
Municipal Act, 2001, Ontario Regulation 653/05 – Debt-Related Financial Instruments and financial agreements.
Agent
means an individual or organization acting
on behalf of the City to provide advice
on price hedging strategy and/or to execute agreements and transaction.
City
means the City of Ottawa.
Commodity
means, whether in the original or
processed state, an agricultural product, a forest product, a product of the
sea, a mineral, a metal, a hydrocarbon fuel, electricity, a precious stone or
other gem and other physical goods but does not include chattel paper, a
document of title, an instrument, money or securities.
Commodity
Price Hedging Agreement is a financial
instrument to fix the cost and/or manage the financial risk associated with the
purchase of a commodity.
Counter
party means a party to a contract which,
for the purposes of this policy, is usually a financial institution or other
entity that is offering the hedging/financial agreement to the City.
Financial
Agreement means a commodity price hedging
agreement including swaps and call option contracts.
Futures
Market means an exchange where commodity
price hedging agreements or “futures contracts” may be purchased or sold.
Hedge
means, in the context of this policy, the
purchase of a commitment to acquire a specified quantity of a commodity, at a
specific price, at some future point in time.
Ottawa
Carleton Energy Purchasing Group (OCEPG) is
composed of a 17 member organization from the area’s municipal, university,
school boards and hospital sectors. This purchasing consortium has been in
existence for 20 years and is involved in natural gas purchases.
Over
the Counter (OTC) refers to a financial
instrument used to hedge the price of a commodity which is entered into with a
financial institution and includes terms and conditions which are specific and
are not publicly traded through an exchange or otherwise.
Inquiries
For additional information contact:
Gerry Mahoney
Manager Treasury, Finance Services
Procurement Strategy for Hydrocarbon Fuels
Such as Gasoline and Diesel Fuel
The City of Ottawa’s objectives for procuring gasoline and diesel fuel
are linked to the City’s business objectives of value for money, and its price
risk tolerance which attempts to provide cost certainty for the Transit and
Fleet clients during each budget cycle.
The City’s procurement strategy for hydrocarbon
fuels will include the following key objectives and components:
·
Manage the
commodity procurement strategy to achieve best overall value to the Corporation
as a whole.
·
Establish
commodity unit rate targets, in conjunction with Finance and user clients that
consider both budget considerations and market conditions at time of purchase
·
Attempt to
deploy either contractual frameworks (typically available through the vendor),
or price hedging strategies (typically available through a financial
institution) to ensure that needs are met within budget, recognizing that:
o budgets are typically set far in advance
of procurement decisions and commodities such as fuel can be effected quickly
by the global economy;
o some flexibility in the approval process
is necessary to ensure demand of these necessary commodities is met;
o these actions are intended to mitigate potential
upward cost volatility;
o in certain cases, these strategies may
actually result in the City paying prices higher than those available outside
of the hedging contract, and that the need for cost certainty is at some times
equal as a consideration to maximizing lowest cost.
·
Attempt to
provide cost certainty to City clients when forecasting costs for budgetary
purposes, by reducing price volatility, through ongoing analysis of the short
and long term market projections in Finance, in conjunction with accurate usage
estimates provided by the operating clients.
·
Employ a
contractual strategy that attempts to set rates in advance, in increments of
25%, 50%, 75% or 100% of estimated needs, for durations of three months or
greater in accordance with the guidelines of the Commodity Price Hedging
Policy.
·
Authorize
the City Treasurer to approve contracts for gasoline and diesel fuel within
approved City budget allocations, and to monitor and report on contractual
commitments in accordance with approved policy.